Islamic finance body AAOIFI issues standard for agency contracts

May 3 (Reuters) - The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has issued its first standard covering wakala, or investment agency contracts, in a bid to harmonise practices for the widely used structure.

The guidance issued late on Wednesday from Bahrain-based AAOIFI, one of the main standard-setting bodies in Islamic finance, aims to address the use of wakala in areas such as over-the-counter instruments, treasury placements and Islamic bonds.

Wakala is common as a standalone product, such as in letters of credit, but AAOIFI opted to focus its standard on more complex instances where it is combined with other contracts.

Embedded wakala now represent a significant portion of the portfolios of Islamic financial firms, said Hamad Al-Oqab, Chairman of the Accounting Board of AAOIFI.

“The increased usage and application of wakala-based instruments by Islamic finance institutions has resulted in divergent practices due to its multiple structures and complexities,” he said.

Islamic banks use wakala for both their short and long-term funding needs, and in recent years have incorporated the contract into hybrid versions of Islamic bonds, or sukuk.

In wakala, one party acts as agent (wakil) for another, managing assets under certain investment conditions.

The AAOIFI standard focuses on this principal-agent relationship, addressing the related accounting treatment and financial reporting of the assets.

AAOIFI’s standard states the relationship does not transfer ownership rights of the assets to the agent, so transactions should be kept off-balance sheet for the agent, while the principal should account for the assets in its accounting books.

The AAOIFI standard also requires the principal to evaluate the nature of the investment at inception, with the preferred option being a so-called “pass-through” investment, a classification often used for asset-backed securities.

The standard will be effective for the financial reporting periods beginning in 2020, although earlier adoption is permitted. (Reporting by Bernardo Vizcaino Editing by Darren Schuettler)